There are so many different words and phrases in banking that sometimes things can get confusing. Take loans and lines of credit for example. These two terms are often mentioned in the same breath, but what do they actually mean? And what do they have in common? In this blog, we’ll give you the scoop on these two important types of credit, and share how they can help you.
What is a Loan?
A loan is a sum of money that a borrower will receive from a lender which they’re obligated to pay back in full, with added interest, over a period of time. There are specific loan terms that the lender will define in the contract that must be agreed upon before any money is advanced.
Individuals, corporations, and governments all have the capability of taking out a loan from a financial institution. Financial loans increase your overall money supply to pay toward a planned or unplanned event, such as buying a new car.
In some cases, loans may be secured or backed by collateral, like a mortgage. Oftentimes lenders will require borrowers to show proof that they own assets (i.e. real estate or a savings account) in order to process the loan. If you’re looking to borrow a large sum of money, there’s a high likelihood that you’ll need to apply for a secured loan. Lenders hold your assets as a form of guarantee that you’ll repay the amount disclosed in the terms, as well as the accrued interest. Two of the most common types of secured loans include auto loans and mortgage loans.
There are also unsecured loans where the borrower does not have to put up any assets as collateral. With this type of loan, the lender thoroughly will assess your financial records to determine your current financial standing. They do this to estimate your capability of paying off the loan, so that they may decide whether or not to award you the loan. Some examples of unsecured loans include credit card purchases, personal loans, and education loans.
What is a Line of Credit?
A line of credit is a flexible loan from a financial institution, like a bank. It’s a defined quantity of funds that you may access when necessary that you can repay immediately or over a period of time specified in the terms. Interest is charged right from the moment the money is borrowed. The interest rates of lines of credit are generally variable, meaning they fluctuate over time. Similar to a loan, borrowers need to be approved by the lender. They will look at your credit rating and possibly your history or standing with them to decide upon your approval.
Rather than being used for funding one-time purchases (i.e. a house or boat), lines of credit can be used in situations in which:
- You need to pay a large sum of money but don’t know the full amount necessary upfront
- A vendor you’ll be paying does not accept credit cards
- A large cash deposit is needed (think weddings)
In a nutshell, a line of credit is intended to be used to supplement funds when it may not be possible to estimate or verify the exact funds needed in advance. They can help you cover your bases in the midst of uncertainty.
You’ve probably started to notice that there are multiple similarities between loans and lines of credit. Here, we’ll give you a breakdown of how they compare.
What Loans & Lines of Credit Have in Common
Both a loan and line of credit:
- Require creditworthiness for approval
- Require repayment of the funds
- Charge interest on any funds borrowed
- Can help you improve your credit score, when managed responsibly
- May offer secured and unsecured options
Difference Between Loans & Lines of Credit
When you take out a loan:
- You have access to the loaned amount once in a lump sum
- It is based on your specific needs (i.e. you need more funds to purchase a home)
- Closing costs will likely be higher than they would for a line of credit
- Interest accrues on the total loan amount immediately
When you borrow a line of credit:
- You have access to a preset borrowing limit that may be used at any time, repaid, and borrowed again
- It can be used for any purpose
- The interest rates will likely be higher than those of loans
- Interest accrues only when the funds are used
Types of Loans
There are many different types of loans, including:
Personal Loans
A personal loan is a lump sum of money that may be borrowed for almost any purpose. The borrower is required to repay it with regularly scheduled payments over a set period of time with interest.
Mortgage Loans
These are specialized loans used to purchase a property. They’re secured by the piece of real estate in question. Borrowers must meet the lender’s minimum credit and income thresholds to qualify. They will perform a loan credit check to determine eligibility. Upon approval, the borrower has to make regular principal and interest payments until the loan is fully paid off.
Automobile Loans
These are used to buy a vehicle and are secured by the vehicle in question. Unless any down payments are made by the borrower, the lender provides the seller with the amount of the purchase price. The borrower is required to comply with the loan terms (i.e. making monthly car payments). If the borrower cannot pay off the loan, the lender could repossess the vehicle and go after the debtor for any remaining balance.
Home Improvement Loans
A home improvement loan can be used by a homeowner who needs to make repairs on their home. The lender may or may not require the borrower to put up collateral. Oftentimes, individuals will approach banks for home improvement loans to pay toward renovations that could increase their home’s value.
Student Loans
These are also called education loans and may be used to fund qualified educational expenses. Federal or private lending programs offer this kind of loan to students. While the student may be the one responsible for repaying the loan, approval often relies on the income and credit rating of the student’s parents. Typically, the payments are deferred while the student is enrolled in school and for the first six months after graduation.
Business Loans
Business loans, a.k.a. commercial loans, are special credit products issued to businesses. They may be used to infuse capital, continue regular business operations, restock inventory, or hire staff.
Debt Consolidation Loans
A consumer may approach a lender for a debt consolidation loan if they are trying to pay off multiple debts at once. These loans are usually unsecured. If the borrower is approved, the bank would pay off all outstanding debts. Rather than making payments to many lenders, the borrower would be required to make one regular payment to the new lender that offered the loan.
Bad Credit Loans
These are simply loans for bad credit. More specifically, they are personal loans from lenders who are willing to work with borrowers who have a low credit score or little credit history. Experts say it’s especially good to compare rates for bad credit loans because they widely vary between lenders.
Types of Lines of Credit
Examples of lines of credit include:
Personal Line
A personal line of credit, also called a PLOC, is a revolving line of credit. It’s a set amount of funds from which you can borrow up to the limit for a set period of time. You draw the amount of money you need from the available balance, and you’d only pay interest on that amount.
Business Line
Business lines are revolving loans that provide borrowers access to a fixed amount of capital. They can be used to meet short-term business needs, such as buying supplies or inventory, paying a supplier, or an emergency fund.
Home Equity Line
This is also known as a HELOC. It’s a line of credit secured by a borrower’s home that provides a revolving credit line to be used for large expenses or to consolidate higher-interest rate debt on other loans.
Disadvantages to Both
While both loans and lines of credit can be very useful, there are some things you should keep in mind as a borrower. For instance, sometimes collateral loans are the only option for borrowers who make less than the required income to qualify for an unsecured loan, or if they have a poor, or minimal credit history.
Additionally, if you’re unable to pay the loan back, the lender is legally able to take possession of the asset you put up for collateral, whether that’s your home, car, or a family heirloom. Then, you’ll owe more money due to fees, penalties, and interest charges that have built up on your account. Defaulting on a loan will cause your credit score to drop, which can take time to build up.
The same applies to secured lines of credit. They also usually have variable interest rates, which means they could raise over time. Unsecured lines of credit can be very convenient, but they’re more expensive than traditional secured loans like mortgage loans. Certain banks may charge a maintenance fee if you don’t use the line within the draw period. Lastly, interest calculations can be difficult to comprehend since lines of credit can be used and repaid on an unscheduled basis. The amount of interest you have to pay in the end may surprise you.
This is why it’s important to shop around to find a bank whose loans and lines of credit best suit your needs; one that’ll work with you.
Contact Highlands Community Bank to Learn About Our Services
Our staff can help you choose the right loan or line of credit for you. We’re pleased to offer flexible, competitive options to the wonderful Alleghany Highlands community. Reach out today!